Derivatives: Why They Matter for Financial Reform

Derivatives, a special kind of investment, played a key role in the financial crisis and generated $20 billion for Wall Street last year. They are also central in President Obama's push for financial reform. Because the value of derivatives is pegged to the future price of other events or instruments, they have been negatively compared to bets. They also play a role in the case against Goldman Sachs. Here's an overview of why derivatives matter, and how they figure into the ongoing push for financial regulatory reform.

Bill Will 'Spin Off' Derivative Traders
The Wall Street Journal's Greg Hitt and Damian Paletta say the regulatory reform
bill "would potentially force banks to spin off their operations that
trade the exotic financial instruments." However, a version of the bill put forward by the Senate Agriculture Committee "could
hand control over the derivatives market into just a few companies, such
as hedge funds, over which regulators have less control."

How
One Kind of Derivative Extended the Recession ProPublica's Jesse Eisinger and
Jake Bernstein report on hedge fund Magnetar, which typified the
abuse of a type of derivatives called collateralized debt obligations
(CDOs). By taking out CDOs that bet the housing market would fail,
Magnetar not only profited from but significantly worsened the housing
crisis and following recession.

Magnetar wasn't the only market
player to come up with clever ways to bet against housing. ... Such
short bets can be helpful; they can serve as a counterweight to manias
and keep bubbles from expanding. Magnetar's approach had the opposite
effect -- by helping create investments it also bet against, the hedge
fund was actually fueling the market. Magnetar wasn't alone in that: A
few other hedge funds also created CDOs they bet against. And, as the
New York Times has reported, Goldman Sachs did too. But Magnetar
industrialized the process, creating more and bigger CDOs.

Regulate Them Like Commodities In the Wall Street Journal, Chairman of the Commodity Futures Trading CommissionGary Gensler explains that
masses of unregulated derivatives, in which banks place bets on other
bets, "has created a system where financial institutions are deeply
interconnected. If a derivatives dealer fails today it can have severe
economic implications across the entire financial system." That's why
the reform bill "would require standard over-the-counter derivatives to
be cleared by central clearinghouses. This will greatly reduce risk,
interconnectedness and the need for future bailouts. Financial
institutions would be freer to fail with limited effects on the broader
economy."

The Downside of Blocking Derivatives The
Atlantic's Daniel Indiviglio warns,
"While it sounds like a fine idea for banks to simplify their businesses
by not dealing derivatives, the provision would harm the market." The
appetite for derivatives isn't going away. Thus, "non-U.S. banks that
are still permitted to deal derivatives will have a significant
advantage for this reason. If a derivatives desk doesn't have a bank
behind it with lots of capital to better ensure its survival, the market
will become less efficient."

Focus on Derivatives Risks
Missing Real Culprit Mother Jones' Kevin Drum writes, "the real
issue is that predatory lending on a large scale helped to massively
inflate the housing/credit bubble of the aughts. If the home loan market
had been regulated stringently enough to keep mortgage lending
relatively sober, the bubble most likely would have been half the size
it ended up at, the credit derivative tidal wave never would have picked
up a lot of steam, the bursting of the bubble would have kicked off a
normal-sized recession instead of a near-depression, and the banking
system would have survived without massive government intervention."

News reports are focusing on the Germanwings pilot's possible depression, following a familiar script in the wake of mass killings. But the evidence shows violence is extremely rare among the mentally ill.